The Sideline Offensive
Company A acquires Company B. Companies C, D and E should view this as their opportunity to strike
April 1, 2008
The relative calm found on the sidelines can often prove to be a welcome respite — especially in a tentative and uncertain market such as the one dealmakers are facing today.
As of March 1, deal activity had been more than halved from the $308 billion in transactions inked during the first two months of last year, according to Thomson Financial, with just $147.9 billion worth of deals coming out of January and February.
PE firms dealing with credit weakness are using the pause to attend to their portfolios. Strategics, on the other hand, had a brief window to take advantage, but have since seen that crack shut closed as questions about the economy put company boards on the defensive. Needless to say the sidelines are getting crowded.
All of this doesn't mean companies can't use M&A to their advantage. Indeed, deals will still happen. Witness Microsoft's hostile bid for Yahoo or the consolidation that is starting to percolate out of the airlines sector. But pursuing the "me-too" transactions isn't necessarily where the opportunity lies today. Rather, to some, it's about keeping track of the M&A occurring in a given segment, and attacking the soft spots that might be exposed as businesses and markets transform.
"The best time to jump-start change is when a competitor is involved in a merger," New York University's Robert Lamb tells Mergers & Acquisitions Journal.
Lamb, a clinical professor of management at NYU's Leonard K. Stern School of Business and co-author of the book "Capitalize on Merger Chaos," has studied this alternative take on M&A for years. While such a strategy may seem obvious, Lamb notes it's most often the case that the "opportunity is squandered."
Ten years ago this June, Compaq ostensibly changed the model for the entire computer industry with its roughly $9 billion takeover of Digital Equipment. Headlines screamed about the pressures facing IBM and Dell Computer as a result. Service was supposed to become an issue, as was pricing power over the suppliers. Michael Dell's response, however, was anything but panic. In an interview with Fortune Magazine, he called the merger "a huge gift." And as Compaq moved to integrate Digital Equipment, Dell, the company, fixed its sights on Compaq's enterprise business accounts.
Lamb calls Dell's ensuing advance the "classic" example of coordinating a sideline offensive. The company, while eschewing M&A as a growth engine for itself, has repeatedly managed to ambush its merging rivals, and usually picks up marketshare in the process. The strategy was repeated three years after the Digital Equipment deal, when Hewlett Packard bought Compaq. Dell used that disruption to attack HP's core printer business.
In the small- and mid-market arenas, the opportunities may not be as obvious as those that emerge out of multibillion-dollar combinations. Lamb contends, though, that they are, in fact, easier to capitalize on, as smaller companies rarely have the expertise or infrastructure needed to coordinate a mistake-free integration and at the same time protect their vulnerabilities.
"Competitors in these markets should have a field day with mergers," Lamb describes. "From the perspective of the acquirers, their direct and indirect rivals are suddenly poaching their best people, suppliers and customers. And all of those guys, in most business combinations, aren't getting the attention that they're used to. Anytime a merger occurs the antenna should go up."
The alternatives
Not everybody is keen to agree with Lamb. When companies in a given sector merge, a typical response from the competition is to merely take note, as opposed to action, or to fall into a defensive posture with the focus turned inward.
"If you're seeing your competitors getting bigger, it means they're gaining economies of scale and gaining an edge on costs," Natan Shklyar, the head of Arthur D. Little's private equity practice tells M&A. "What you should do in that case is focus relentlessly on operational improvements."
Another response — one that was readily available 18 months ago — is for the companies on the sidelines to enter the M&A market themselves, either as a buyer or seller.
"You'll often see these feeding frenzies in a particular industry," Harris Williams & Co. managing director William Roman says. "If you've got five competitors in a given space and two merge, everyone left usually asks whether or not they are buyers or sellers, and if not, are they positioned to survive on an independent basis?"
The activity currently seen in the video game industry might fit this description. For the past two years, the independent players sought refuge through sales to the larger names in the space, and now the industry leaders are seeking out multibillion-dollar combinations. Late last year, Vivendi acquired Activision, creating the largest company in the industry while raising the stakes for its rivals in the process. In February, Electronic Arts responded with an unsolicited bid to acquire Take-Two Interactive. As of press time, Take-Two had rejected EA's advance.
Lamb, however, believes that a copycat deal can be the most treacherous path a company can take when confronted with consolidation. He notes that parallel transactions are rarely as well thought out as the original deals. Moreover, when M&A activity heats up, successive transactions tend to fetch higher prices than the deals that started the trend, putting the second and third combinations at a distinct disadvantage.
But aside from chasing after a reactive deal, Lamb notes that the second biggest blunder a business can make is to do nothing.
"Companies look at M&A as gossip or water cooler talk, as opposed to seeing it as an opening," he says. "They don't realize that these transactions present opportunities, so the news just goes by in a blur."
Others back up this sentiment. "In the middle market, it's unusual for companies to view deal activity as a strategic inflection point," says Edward Hess, a professor of business administration and Batten executive in residence at the University of Virginia's Darden Graduate School of Business. "You don't generally see a proactive response from competitors. ... But this is probably the best time to turn up the heat."
The soft spots
Thomas Flaherty, a senior vice president in the Dallas office of Booz Allen Hamilton, says that planning a response to market consolidation should be something companies think about months or even years in advance. "Every company should have performed a scan of their respective industries to determine the attractive targets," he says. "Then they need to assess their own capabilities and strategic positioning to know whether they can withstand a combination of competitors."
This kind of evaluation is something most Fortune 500 companies perform routinely, according to Flaherty, but he notes that smaller and intermediate sized companies rarely map this out, since they're "not as transaction experienced" as their larger peers.
But conviction is important. And just as two merging companies prioritize speed in the integration phase of a deal, competitors need to move even quicker if they intend to expose any vulnerabilities that may develop. Within weeks, competitors need to digest the transaction, identify the areas to attack, and move quickly in doing so. Some of the factors to be considered are: who's buying the company; do they have a strategy in place; how much debt is being added; and most importantly, where are they vulnerable.
"It's a chess match," says Ernst & Young's Jonathan Keefe, who works in the Boston office of the firm's transaction advisory services group. "You have to be quick to effectively counter."
When Edward Lampert combined Sears and Kmart his overarching premise revolved around slashing capital spending and trimming the marketing budgets, while at the same time, boosting product prices. Market watchers keeping track may have recognized the blueprint from Lampert's previous investment in car parts retailer Autozone.
What Lampert didn't count on, though, was that Sears' competitors would take the opposite approach. Target, for instance, saw its capital expenditures climb in successive years from 2004 to 2006 thanks largely to new store expansion and a remodeling program. It also poured more money into advertising. Sales at the two companies, not surprisingly, went in opposite directions.
Non-traditional competitors like Home Depot also took advantage of the upheaval. The company branched out, further expanding into appliances, and ultimately succeeded in cutting into a core part of Sears' business.
"The best thing you can do is to anticipate what kind of disruptions might occur during integration and any major changes that will come out of a deal," says Jeff Gell, a partner and managing director with Boston Consulting Group. "You have to know precisely when those pain points are going to emerge, so you can go in and proactively push the right buttons."
One obvious soft spot that is routinely attacked in a merger is the brain-trust — not necessarily the people behind the deals, but rather the employees who make the company tick.
Cushman & Wakefield employed this strategy last year when it poached four key executives from London consultancy DTZ in November. The four pros in question joined DTZ in July as part of its GBP40 million acquisition of Donaldsons, and defected to Cushman & Wakefield just a few months later.
Another segment ripe for attack are the suppliers to the companies involved in a merger. They realize that consolidation translates into getting squeezed on costs, so as a preemptive counter, they'll seek out other channels to sell into as a way to diversify their customer base.
The most vital area up for grabs is the combined customer base of the merging companies. As anyone who has gone through an integration process can attest, attention very easily gets diverted in a merger. It might mean customers' calls go unreturned or maybe, as seen in the case of Sears, pricing gets ratcheted up. Even if these scenarios don't develop, clients may habitually think about alternatives as a precaution.
Linda Gridley, the president and CEO of information services-focused boutique bank Gridley & Co., notes that customers are always going to scrutinize transactions. And that, in turn, creates the opportunity. "It's one of the biggest areas [competitors] should focus on during the integration period," she says.
Boston Consulting Group's Gell adds: "Customers may see their sales reps changing. They may be scared about the continuity of business or worried that manufacturing is going to be moving to Indonesia. Going in preemptively and pushing real hard with the customers can be the best attack."
At the very least it puts those concerns on a client's radar.
Sometimes, it's a combination of factors that work together to upend a merger. Take the case of marketing services company Epsilon. It bolstered its email marketing division with successive acquisitions of Bigfoot Interactive and DoubleClick's email division. An ensuing culture clash led to a rash of employee defections, followed by an attempt to migrate clients to an unfamiliar delivery platform. It didn't take long before costumers started to flee, landing with rival companies such as GSI Commerce and others.
The key, though, is speed. Whether going after employees, suppliers or clients, doubt is a friend to the competition — but these misgivings fade over time.
"The best times to strike are when deals are announced. There's a lot of uncertainty and an initial paralysis. People can't make decisions," Gell says. The other time to strike, he adds, is "shortly after the close," when the attention is focused on executing the 100-day plan. After 12 to 18 months, however, it's usually too late to capitalize.
The best defense ...
To be sure, most ardent M&A pros may never consider themselves to be out of the market in the first place. Deals may be difficult to find, but it doesn't mean they're not turning over every stone.
"It's not a straight line," Booz Allen's Flaherty notes, describing his view of what "the sidelines" really signify. "At any point in time it means different things to different people. There's a degree of unevenness in terms of how far away people are from truly being active. It can change at any moment."
But Lamb notes that attacking deals when they happen can often serve two purposes. The first is that it increases the rate of failure. The second, and a corollary of the first, is that it creates deal opportunities over time — again, changing the meaning of "sideline."
He points to the recent sale of Chrysler, which was the result of a failed integration. Lenox Group, Sirva, Buffets Holdings are examples of companies that bought heavily over the years and are now reportedly shopping properties to pull themselves out of a hole.
However, the most important factor in tracking competitive mergers and acting on them is a reversal of the chestnut that the best offense is a good defense.
"All of a sudden you're going to be facing a competitor that cares more about a particular business," Gell says, alluding to the merging companies. "They'll have lower costs, perhaps more innovation, better geographic coverage and maybe a brand advantage. It should make your hair stand on end."
In fact, it's the immediacy of the threat emerging out of a merger that should motivate a business to become proactive. And the alternative of sitting back and waiting to see what happens shouldn't be an answer, whether a company is on the sidelines or not.
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